While there has been some progress in recent years, the new corporate governance code, expected to be adopted by companies in June, will support further progress.
The new code is one of the key pillars of the Japanese government’s revitalisation strategy. Its key areas – cross-shareholding and accountability to shareholders – are particularly important to investors as they will encourage greater capital efficiency and focus on shareholder returns.
Under the new rules, Japanese companies will be obliged to disclose rationale for cross-shareholding.
Firms often explain the rationale being that they cement relationships with customers and partners.
This may be true, but if they follow the new code, they will need to give a detailed explanation of what the monetary value of this relationship is and why they cannot undertake it without cross-holdings.
While many companies hold the shares for historic reasons, this does not justify the continuation of such holdings. Japanese companies spend a lot of money trying to develop products for the future and they must take a similar attitude with their capital structure.
Cross-holdings give a false sense of safety – these are on paper valuable assets, which should offer security on a rainy day. The difficulty is that when that rainy day comes it generally coincides with a weak stock market. They also depress reported ROE, increase asset volatility and are significantly discounted, or ignored, in company valuations.
However, we are mindful that part of the reason behind the recent rally in the market has been an improvement in the supply and demand, with an increased demand from pension funds and the BoJ helping to push the market higher. Cross-shareholding unwinding could add supply into the market and upset the balance.
Any unwind is likely to take years and should ideally go hand in hand with companies undertaking more share buy-backs. The fact that unwinding of shares is going to take many years is not a problem, as little value is currently ascribed to a company’s cross-shareholdings.
With evidence that this value is being realised over time, the discount placed on these holdings may narrow and stocks could be re-rated. This could create meaningful upside for share prices. The requirement for greater disclosure and clarity from companies about their strategies could trigger this change.
Looking at accountability, Japanese companies are well known for taking their responsibilities to all stakeholders seriously. As the corporate governance code encourages dialogue, one of the chief responsibilities of any company, in addition to balance sheet efficiency, is to outline exactly how it plans to allocate net income.
Companies should allocate 100% of net income for a specific purpose rather than retained earnings building up on the balance sheet as cash. We are open minded about whether these are returned to shareholders or invested for growth.
All we ask is that there is a dialogue with investors outlining how the allocation decision was made and what criteria were used in making that decision. The introduction of the new code should encourage this dialogue.
While there has been a certain amount of criticism voiced about the government’s third arrow reforms, it is encouraging how active the government has been in developing the corporate governance code for companies and the stewardship code for institutional investors.
While investors cannot expect changes overnight, these codes will help end the passivity that has existed for many years on corporate governance and shareholder issues in Japan, which remains an interesting market ripe with opportunity.
